The End of Exorbitant CEO Exit Packages? Don’t Hold Your Breath

Leo Apotheker, the former CEO of Hewlett-Packard, resigned last September after just 11 months on the job — but he left with a $13.2 million severance package.

Craig Dubow, the former CEO of newspaper publisher Gannett, resigned in March after six years at the helm and walked away with $32 million.

Eric Schmidt, who led Google for a decade, resigned in January 2011, exiting with an astounding $100 million golden parachute.

On the surface, these amounts paid out to exiting CEOs seem egregious, especially in situations where the CEO preformed badly (in Apotheker’s case) or the company was making deep cuts (in Dubow’s case). Exiting executive compensation is only doled out at around 50% of Fortune 500 companies, and “in general, there are good reasons to have exit packages,” Wharton accounting professor Wayne Guay says. “Most firms are thinking through what they are doing and most are getting it right.” But when a firm’s shareholders and employees feel the exit package represents a true injustice, it can have a profound negative effect on employee morale and on the company’s overall performance.

The basis for many exit packages is severance and other bonuses promised long ago when the CEO was hired. In fact, a January 2012 study by the corporate governance firm GMI Ratings looking at the top golden parachutes since 2000 found that the majority were composed of an accumulation of large equity grants, pensions and deferred compensation from previous years.

Wharton finance professor Luke Taylor notes that severance is a useful tool in negotiating hiring contracts because it allows a company to offer CEOs less in annual salary, but it also gives CEOs the confidence they need to improve the company. “Taking a risk might be right for shareholders, but the CEO might not do it if it could cost him his job,” he says. “Somehow, with this cushion, a CEO is willing take risks.” Severance also ensures that a top leader does not stay on longer than he or she should, according to Guay, particularly when there is a merger and one CEO has to leave. “It encourages a CEO to take a walk when it is best for the company.”

Still, many question why CEO severance and bonus packages have become so outsized in the first place, particularly in light of the 2008 financial crisis. In 2011, average CEO compensation (including salary and stock options) was 209 times greater than the average employee’s pay, according to a 2012 study by the Economic Policy Institute. In 1965, the ratio was just 18 to 1.

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Michael Useem, Wharton professor of management and director of the school’s Center for Leadership and Change Management, says that huge payouts have become the norm as multi-billion dollar companies seek to keep up with their competitors and the growing demands in “the kingdom of CEOs. If you want an above-average CEO, consultants are going to show you this kind of compensation data,” he notes. “And if you want extremely good people, you are going to have to pay, or you will ultimately, in a sense, pay for it another way.”

Exit Package Excess

While shareholders can often justify severance and pension payments, what really makes headlines is compensation in the form of separation agreements and payouts determined at the end of a CEO’s tenure. In fact, only 13% of CEOs of Fortune 500 companies who left — either voluntarily or involuntarily — from 1993 to 2007 had a specific severance contract in place before they decided to leave, according to a 2010 study by Indiana University professors Eitan Goldman and Peggy Huang. On the other hand, 47% received some kind of bonus at their departure.

One of the main reasons for excessive exiting compensation, note Goldman and Huang, is to “facilitate a smooth and efficient transition from the previous CEO to a new one,” particularly in cases when the outgoing leader is forced out. Taylor adds that many companies feel an extra $10 million or $20 million is worth it if it means the firm gains an extra two months under new leadership. In fact, when a CEO is forced out, the worse their past performance, the greater the separation pay, according to Goldman and Huang’s study. “It allows the CEO to quietly go into the dark night,” Taylor says. “If you are worried the CEO will sue the firm or [go to] work for a competitor, you can just pay the guy off.”

However, rather than paying off a bad CEO, Wharton legal studies and business ethics professor Thomas Donaldson questions why more companies don’t just fire them — making much of any promised or assumed compensation package null and void. “We fire for cause inside an organization,” notes Donaldson, who is also director of the School’s Zicklin Center Business Ethics Research. “We should use the tool of firing for cause more often in the board room.”

Some argue that firing CEOs would make incoming executives wary of taking the job, but Donaldson suggests that the lack of firings really comes down to friendships and coziness between the board and CEO, even if the CEO has done wrong. “The problem is, it’s a lot easier to be generous,” he says.

Injustice and Loyalty

Most companies that pay out exit packages upwards of $10 million, or even $50 million, can typically afford to do so, and the cost will barely make a dent in earnings. But there are other costs they risk incurring, such as a decline in company morale or a drop in stock price. “The [payouts] that get a lot of attention are usually not particularly costly to the firm,” Guay notes. “The reason they get so much scrutiny is that they happen to be paid right at the time people are fed up with that individual. And it just smacks of a sense of unfairness.”

This feeling of injustice is what can prompt employees to feel disconnected from the company. “When a package looks manifestly unfair, it sends a message to the company that the board is not really trying to get great performance for great pay,” Useem says. “In the short term, it could be fundamentally demoralizing to the company.”

Additionally, such outsized packages could prompt employees to look for jobs elsewhere or give minimal effort in their current positions because they feel betrayed by their employer, notes Donaldson. “The extent that ex-CEOS are treated like an elite group that is apart from the rest of the firm really is a red flag for many employees, and it can really affect their sense of loyalty to the firm.”

When it comes to a more tangible direct effect, the impact on a company’s stock price usually depends on the circumstances behind a CEO’s exit. Taylor says that when a leader is fired after poor performance and paid a big severance, the stock price typically does not move — suggesting that shareholders saw the exit coming and are happy to see the old CEO finally out. But when the CEO leaves the firm voluntarily and gets a big exit package, the stock price typically goes down, he adds — suggesting that shareholders feel the board is making poor decisions and not working for their interests.

Regulatory Changes

The peak of large CEO compensation packages came in 2002 and then came quickly crashing down after the Enron and WorldCom scandals and passage of the Sarbanes-Oxley Act, which strengthened reporting standards for public firms. The scandals also prompted a review of how executive payouts are disclosed. In 2006, the Securities and Exchange Commission issued requirements that companies disclose all benefits in financial statements if they exceed $10,000 in one year.

That move has been one of the most effective regulations when it comes to tightening exiting CEO packages, according to Guay, and it has basically gotten rid of tax gross ups — which occur when a company makes up for the difference a CEO has to pay in taxes by offering non-cash perks like the use of a private jet or moving expenses. “Shareholders do not like these types of perks,” Guay says. “And because of the recent scrutiny, tax gross ups are going away.”

More recently, the Say-on-Pay statue in the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in reaction to the corporate excess and risk-taking that fueled the 2008 financial crash, is moving past disclosure and letting share holders weigh in on compensation. The SEC implemented the rule in January 2011, requiring all U.S. public companies to provide their shareowners with a non-binding vote to approve the compensation of the top five senior executives. In 2011, there were 2,340 Say-on-Pay votes but only 37 companies had a majority of shareholders vote against proposed compensation packages.

While the rule might be effective at prompting boards to better explain themselves when deciding on compensation packages, involving shareholders in the decision is going about it the wrong way, according to Guay. “I think it is a little ‘pie in the sky’ to think that [shareholders] are going to get it right. They don’t have time to scrutinize everything, and they are not privy to all the inside information,” he says. “That’s why this duty has been delegated to the board.”

Still, Useem notes that public outcry has done little to change CEO compensation, and he does not think the Say-on-Pay rule will have much of an effect, especially as the vote is non-binding. “Companies have been resistant and resilient when it comes to demands from the media and government and compensation critics,” he says. “I would not hold your breath waiting to see a change in compensation for exit packages.”